I am a long term buy and hold investor who focuses on dividend growth stocks

Friday, October 30, 2015

How to Increase Dividend Income

I expect that this year, I will be able to cover something like 60 - 80% of my targeted annual expenses from dividends alone. This means that my forward dividend income will cover 60% - 80% of my expenses. My forward dividend income is the amount of dividend income I will receive over the next year from investments I have today. It assumes no reinvestment of dividends and no new capital being added.

I believe that sometime around late 2018, my forward dividend income will be able to exceed my target monthly expenses and also have a neat little margin of safety as well. A margin of safety is important, because I want to have the luxury of never having to work for money again. A retirement where I have to spend time at a low paid part-time position does not seem appealing to me. This is why I believe generating a little more in dividend income than I need to is important, even if that means working an extra year.

As I get closer to the finish line, I am starting to get a lot of ideas on how to increase dividends faster. You might remember this post that I wrote over an year ago. I think it is time to re-visit the ideas, and add some more meat.

Before I get down to basics, I want to say again what I am looking for from my dividend portfolio. I expect to generate a stream of dividend income which grows above the rate of inflation. The majority of dividends from my portfolio should be coming from at least 50 – 60 individual dividend paying stocks. The portfolio should include as many industries that make sense. Each of those companies should be growing earnings to pay the rising dividend, and should have a payout ratio that is sustainable. I believe that a reasonable dividend yield in today’s world for US stocks is around 3%.

Now I will start getting down to basics. In order to increase dividend income, an investor can do several things:

1) Buy more stocks that pay dividends

The easiest way to increase dividend income is by buying more shares that pay dividends. For the past eight years, I have meticulously saved money and invested them in income producing assets such as dividend growth stocks. For example, I recently saved some money to be able to invest in VF Corp (VFC) and Target (TGT). The downside is that you need to be able to get capital to allocate. We all know that it takes time to save and invest enough each month, before this portfolio can generate enough dividend income to actually live off of. This process can easily take anywhere from ten to twenty years of saving a lot and investing every single month. Of course, once you are retired, you will not be earning much money. Therefore, your income will not be able to increase this way.

2) Reinvest dividend income into more dividend paying stocks

Another easy way to increase dividend income is by reinvesting dividends. A stock like Verizon (VZ) that pays a 5% dividend, where dividends are automatically reinvested, will produce more dividend income every single year to its shareholders. The problem of course is that if you need to live off income in retirement, you will not be able to grow dividends by much. Given the ten year dividend growth rate of 3.30%/year, this mostly keeps up with historical levels of inflation.

3) Sell existing holdings and purchase higher yielding ones

This is one thing that many investors have asked me about on the site. I am usually against this strategy, because it usually involves selling lower yielding companies today in order to buy a higher yielding company. If you sell an appreciated investment, you will end up paying steep capital gains taxes.The problem is that the lower yielding company can provide growth in dividends and sustainable dividends due to a lower payout ratio. Furthermore, those companies can provide you with a higher potential for capital gains. This is because lower yielding companies typically tend to grow earnings faster than normal. The higher yielding companies in my view are usually riskier because they are flow-through entities (REITs, MLPs, BDCs), and as such pay almost all of their cashflows as distributions. This is all fine and dandy, until there is a recession, and many of those companies are pressured to cut distributions because of a temporary decreases in profits.

In other words, replacing lower yielding for higher yielding stocks is destined to change the risk profile of your portfolio ( hint: It will make it riskier because you will be holding companies which could crumble under similar circumstances such as rising interest rates or lack of cheap access to financing or change in favorable tax treatment of corporate structure). It is yield chasing, and I think that this is a dangerous situation to be in. In addition, when you sell all your lower yielding securities, your dividend income will no longer be able to grow by much.

4) Buy stocks that grow dividends over time

As evident by the title of the blog, I favor companies that grow dividends over time. This is because when I retire, I may not work for money again. As a result, I need companies that will grow dividends on their own, and will have the business models to support growing those dividends over time. This is why organic dividend growth is so important to me, and why I spend time researching companies in order to determine valuation, whether earnings have been growing, and whether the dividend payout is sustainable. A prime example is Johnson & Johnson (JNJ), which has raised dividends for 53 years in a row, and will likely keep raising them for years to come.

There is of course a trade-off between yield and growth as I have mentioned before. I do tend to mix and match companies in the three different types of dividend companies. I also try to avoid purchasing companies that just raise dividends nominally for the sake of raising dividends. I want a decent yield today, and an adequate dividend growth in the future.

Obviously, a company that yields 2% better have a growth above 7%. At the same time I cannot expect double digit growth from a company yielding 5% - 6% - a 3% distribution growth to match rate of inflation should be satisfactory over time ( as long as it is supported by fundamentals of course).

5) A combination of all of the above

As usual, the best outcomes should not be a polarizing this or that, and nothing else. I have found that a solid mix of adding fresh capital monthly, reinvesting dividends selectively, and then passively holding for the long-term is the best situation to be in. I have also found that failing to take advantage of tax-deferred accounts such as a 401 (k) or a Roth IRA could prove to be costly down the road. It is much easier to compound your money when you get a hefty tax-break upfront, and tax-free compounding for decades. As I have mentioned before, I try to keep three different types of dividend growth stocks. My portfolio is like a symphony - each company in it has a role to play and together they make beautiful, income producing music.

Disclaimer

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